The Canadian economy is showing several signs of cross asset convergences. Is it for real? The first chart below shows for instance that, after several months of total disconnect, the ratio of the S&P 500 to the TSX has finally recoupled with the economic news indexes spread. If the regime switch is here to stay, then the TSX outperformance against U.S. equities should come to an end.
This message is not confirmed by oil prices though. As can be seen below, the recent price action would suggest an outperformance of TSX against the S&P 500. For those who do not track the Canadian economy on a regular basis, this could seem at odds with the status of Canada as an oil producer and exporter.
Yet, as can be seen below, the correlation between the relative performance of S&P 500 to TSX on one hand, and Brent prices on the other, has utterly changed since the Great Recession. It used to be strongly and significantly negative. It is now meaningless.
There might be a tentative move back to previous levels but it is far from convincing. In addition, the correlation break could be explained by many factors. The U.S. economy is becoming a net exporter of refined products whose prices are linked to that of Brent. Over the period, and in spite of an inversion recently, the spread of Brent with the Canadian reference - the WCS - has widened, harming Canadian companies. Add to this the growing investment cost for Canadian oil producers (among others as, since 2005, total Capex for global oil majors has risen from 100 billion USD to 300 billion USD while their total output fell from 17 mpd to 14.5 mpd).
On the FX front, the USD/CAD is struggling to converge towards the level implied by the spread of OIS swap curves. Does it mean that the fair value of the pair is closer to 1.05 than 1.08/10?
Not necessarily. I do prefer, for foreign exchange, returns (changes) to level analysis, as the latter may fail to catch regime switch. The same chart based on 1-month changes would suggest that there is still some potential for a further increase of the USD/CAD. Given that Poloz is more and more perceived as a dove and the Fed ready to tighten, the spread of the short end of swap curves might widen further - in spite of Yellen's efforts to steer and tame early hike expectations.
The same analysis based on 10-year Treasury spreads leads to a similar conclusion: it was more the sharp appreciation of the CAD that was an oddity in Spring than the current reading of the pair.
It might have been linked to the geopolitically-driven rise in oil prices. Not completely. The USD/CAD, which stopped being a commodity currency for a few quarters in 2012/13, seems to be willing to re-couple with Brent prices. But even though the sign of the correlation is back to negative territory (see below), it remains within the boundaries of statistical insignificance…
In addition, even if we try to use Brent price to provide a sense of directionality to the USD/CAD, the chart below suggests that the potential upside to expect for the USD/CAD from the 1-month change of Brent prices is rather limited (and that the fall earlier this spring clearly overshoot what oil prices suggested).
Bottom Line: In spite of some tentative signs of mean reversion, many traditional relationships involving Canadian assets are still struggling to recouple with their pre-financial crisis patterns. In particular, oil prices remain disconnected from both stock markets and the exchange rate. In a global context of stalling trade, the key world for 2014 remains domestic growth and policies. Fiscal policy may be less of a drag in Canada but in a context of lower wage growth and (temporarily) higher inflation, the uncertainty pertaining to the swiftness of the adjustment in the housing market remains a threat for the next few months on growth and asset prices.
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